Founded in 1993 by brothers Tom and David Gardner, The Motley Fool helps millions of people attain financial freedom through our website, podcasts, books, newspaper column, radio show, and premium investing services.

This Just In: Upgrades and Downgrades

Goldman reaches an epiphany: ARM Holdings is a "buy."

At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." So you might think we'd be the last people to give virtual ink to such "news." And we would be -- if that were all we were doing.

But in "This Just In," we don't simply tell you what the analysts said. We'll also show you whether they know what they're talking about. To help, we've enlisted Motley Fool CAPS, our tool for rating stocks and analysts alike. With CAPS, we track the long-term performance of Wall Street's best and brightest -- and its worst and sorriest, too.

And speaking of the best...For the third day running, shares of ARM Holdings(Nasdaq: ARMH) are plunging. That's hardly the reaction you'd expect to see in the wake of an upgrade to "buy" from the friendly analysts at Goldman Sachs. What's going on here?

According to Goldman, the reason to buy ARM today boils down to Microsoft(Nasdaq: MSFT). Several days back, the software giant confirmed that its new version of Windows will be written to run not only on Intel(Nasdaq: INTC) and Advanced Micro Devices(NYSE: AMD) chips, but also on ARM-based designs.

Goldman thinks this "opens new doors" for ARM. The company could apply its patents to, and gain revenue from, as much as 45% of the computing market by 2015, more than quadrupling ARM's current market share. Better yet, Goldman argues that ARM's royalties per device could more than double from their current level of 1%.

With a little quick calculator work, you can see why the numbers have attracted Goldman's notice. Goldman predicts something more like a threefold rise in profit over the next five years, but still, that's a pretty attractive proposition.

Nice work, but…What took you so long, Goldman? ARM shares have nearly tripled in price over the past year -- and you're just now telling us to buy it?

Still, in Goldman's case, a late arrival may be better than none. The majority of the semiconductor picks we have on record for Goldman have outperformed the market -- with a few notable missteps:

Companies

Goldman Said:

CAPS says:

Goldman's Picks Lagging S&P By:

Maxim Integrated(Nasdaq: MXIM)

Outperform

****

34 points

Micro Technology(NYSE: MU)

Outperform

****

32 points

Marvell Technology(Nasdaq: MRVL)

Outperform

****

5 points

Alas, I think this week's Johnny-come-lately endorsement of ARM Holdings will cost Goldman even more.

Valuation mattersARM may be a fantastic company, poised for an uber-profitable future. Yet after tripling in price so quickly, ARM shares now "price in" all the success they're slated to enjoy -- and more -- for years to come.

Right now, ARM shares sells for nearly 100 times trailing earnings. Follow Goldman's projection of a stunning three times rise in earnings, and you're paying 33 times 2015 profits at today's price.

Most analysts on Wall Street take a dimmer view of ARM's profit projections, predicting that the company will grow its earnings at about a 13.5% annual clip over the next five years. And at the risk of stating the obvious, paying 100 times earnings for 13.5% growth is a recipe for disaster, folks. That's a 7.4 PEG ratio!

Foolish final thoughtAdmittedly, things probably won't get that bad. ARM could grow faster than Wall Street currently projects; it's beaten earnings estimates in each of the last four quarters, after all. Also, the shares aren't quite as expensive as GAAP numbers suggest. For last year, the most recent for which we have complete sales data, ARM generated free cash flow equal to more than 220% of its reported GAAP "profits." That free cash flow is growing rapidly.

Regardless, while the valuation on this stock isn't quite as off-kilter and some data would suggest, ARM's still a mighty pricey stock. And investing in it at today's prices -- even on Goldman's say-so -- seems mighty dicey.

Fool contributorRich Smithdoes not own shares of, nor is he short, any company named above. You can find him on CAPS, publicly pontificating under the handleTMFDitty, where he's currently ranked No. 737 out of more than 170,000 members. Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.The Motley Fool has adisclosure policy.

Author

I like things that go "boom." Sonic or otherwise, that means I tend to gravitate towards defense and aerospace stocks. But to tell the truth, over the course of a dozen years writing for The Motley Fool, I have covered -- and continue to cover -- everything from retailers to consumer goods stocks, and from tech to banks to insurers as well. Follow me on Twitter or Facebook for the most important developments in defense & aerospace news, and other great stories besides.